Early stage startups understandably seek to minimize corporate overhead and devote every penny to customer development, engineering, marketing and so forth. Nevertheless, if you want or need the benefits of a business entity such as a corporation or LLC, there are some unavoidable expenses associated with their “care and feeding.” (Legal expenses are outside the scope of this post; my “manifesto” on the subject can be found at Quora.)
I wrote last week about the unpleasant (and misleading) franchise tax bill that arrives on the doorstep of new Delaware corporations this time of year. Franchise tax has nothing to do with “franchises” in the colloquial sense such as fast-food restaurants. Rather, it is a state’s way of charging a business entity for the privilege of doing business as a separate legal “person” from its owners. In states such as California, it also serves as a vehicle for imposing corporate income tax.
Without delving into the complexities of corporate taxation, it makes sense to divide companies into two categories: Profitable (by tax accounting definitions) vs. loss-generating. Profitable companies in general need to calculate state taxes by applying a percentage or formula to the company’s net income in a given tax year. (That said, Delaware has its own methods based on either the number of authorized shares or the assumed par value capital of the company, which is calculated using total gross assets, not income.) Most startups generate operating losses in their first years of business, putting them in a position to pay only the minimum annual franchise tax in the relevant state(s). As of this writing, that figure is $800 in California and $75 or $350 in Delaware depending on the method used.
Which are the relevant states? Sometimes this is an obvious question, other times a fiendishly complex one. The short answer is that a company will be taxed in the state in which it is incorporated and in each state in which it is found to be doing business. States have their own ways of determining whether a company incorporated elsewhere is deemed to be doing business in the state, in which case they are required to qualify or register as a “foreign” (meaning out-of-state) corporation. Common tests include having employees, assets or facilities located in a given state or making sales by shipping a product to residents of that state.
To use a concrete example, consider an Internet startup headquartered in San Francisco with one or two designers or developers working remotely from New York. If it organizes as a California corporation, it will pay $800 minimum annual franchise tax in California. If the team members working in New York are deemed to create enough of a presence there that the company is “doing business” in the state (evaluated under NY law), the company will be required to file an “application for authority” with the State of New York as a “foreign” corporation and pay NY state tax accordingly. If the startup chooses to organize as a Delaware corporation, it will pay minimum Delaware franchise tax ($75 or $350 depending on the method used) and it will need to qualify as a foreign corporation with the California Secretary of State, paying the same minimum franchise tax in California ($800), plus it may also need to register and pay tax in NY as described above.
If a company is not physically present in a state (usually the case with Delaware corporations), it must appoint a local business to serve as agent for service of process. Many service providers compete to offer this service, which does double duty as a filing agent, meaning the service will also hand-file documents, retrieve certified copies and order certificates of good standing from the Secretary of State’s office. From the state’s point of view, requiring a registered agent improves corporate accountability by enabling residents to file suit against foreign corporations without leaving the state. It also facilitates the collection of taxes. These services charge approximately $200 per year minimum to serve as registered agent. Some companies even use a registered agent in their home state, given the relatively modest expense involved.
Most corporate filings made with government agencies involve some kind of filing fee. For example, Delaware charges $89 to file a Certificate of Incorporation for a new company, $50 to obtain a certificate of good standing. The filing agent adds a service charge covering its own role. With a few exceptions, such as some regulatory filings made in connection with securities offerings, filing fees tend to be modest.
Adding it all up, none of these fees or taxes are exorbitant, but it’s important to include and plan for these expenses as part of both start-up and ongoing annual corporate overhead. When in doubt, check with a tax advisor in your state.
This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship. All opinions expressed are those of the author, and do not necessarily represent those of Gust.